What is the 'Periodic Interest Rate'

The periodic interest rate is the interest rate charged on a loan or realized on an investment over a specific period of time. Typically, lenders quote interest rates on an annual basis, but in most cases, the interest compounds more frequently than annually. As a result, the periodic interest rate is the annual interest rate divided by the number of compounding periods.

BREAKING DOWN 'Periodic Interest Rate'

For example, the interest on a mortgage is compounded or applied on a monthly basis. If the annual interest rate on a mortgage is 8%, the periodic interest rate used to calculate the interest assessed in any single month is 0.08 / 12 = 0.0067 or 0.67%. This means that every month, the remaining principal balance of the mortgage loan has a 0.67% interest rate applied to it.

The Effect of Compounding Periods on Periodic Interest Rates

The number of compounding periods directly affects the periodic interest rate of an investment or a loan. For example, if an investment has an effective annual return of 12%, and it compounds every month, its periodic interest rate is 1%. If it compounds daily, its periodic interest rate is 0.00033 or the equivalent of 0.03%.

The Effect of Compounding Periods on Investments

The more frequently an investment compounds, the more quickly it grows. To illustrate, imagine two options are available on a $1,000 investment. Under option one, the investor receives an 8% annual interest rate and the investment compounds monthly. Under option two, the investor receives a 8.125% interest rate, compounded annually. By the end of a 10-year period, the $1,000 investment under option grows to $2,219.64, but under option two, it grows to $2,184.04. Although the interest rate is higher in option two, the more frequent compounding of option one yields a greater return. The greater number of compounding periods allows interest to be earned on interest a greater number of times.

Effective Rate Versus Periodic Rate

When discussing loans or investments, the annual interest rate quoted is typically a nominal interest rate, and the effective interest rate is the actual interest rate after the effects of compounding have been taken into account. To calculate a loan's effective annual interest rate, you need to know its nominal rate and the number of compounding periods. First, divide the nominal rate by the number of compounding periods. The result is the periodic rate. Add this number to 1 and take the sum by the power of the number of compounding interest rates. Subtract 1 from the product to get the effective interest rate.

For example, if a mortgage that compounds monthly has a nominal annual interest rate of 6%, its periodic rate is 0.5%. When you convert the percentage to a decimal and add 1, the sum is 1.005. This number to the 12th power is 1.0617. When you subtract 1 from this number, the difference is 0.0617 or 6.17%. The effective rate is slightly higher than the nominal rate.

RELATED TERMS
  1. Discrete Compounding

    Discrete compounding refers to the method by which interest is ...
  2. Stated Annual Interest Rate

    A stated annual interest rate is the return on an investment ...
  3. Annual Equivalent Rate - AER

    Interest that is calculated under the assumption that any interest ...
  4. Automatic Reinvestment Plan

    An automatic reinvestment plan is a mutual fund plan that automatically ...
  5. Back Fee

    A payment made to the writer of a compound option in the case ...
  6. Compound Net Annual Rate - CNAR

    The compound net annual rate (CNAR) is the return earned on an ...
Related Articles
  1. Investing

    Understanding the Power of Compound Interest

    Understanding compound interest is important for both investing and borrowing money.
  2. Investing

    Continuous compound interest

    Different frequency in compound interest results in different returns. Check out how continuous compounding accelerates your return.
  3. Investing

    Learn simple and compound interest

    Interest is defined as the cost of borrowing money or the rate paid on a deposit to an investor. Interest can be classified as simple interest or compound interest.
  4. Investing

    The Effective Annual Interest Rate

    The effective annual interest rate is a way of restating the annual interest rate so that it takes into account the effects of compounding.
  5. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
  6. Investing

    4 Ways Simple Interest Is Used In Real Life

    Simple interest works in your favor when you're a borrower, but against you when you're an investor.
  7. Investing

    How to calculate your investment return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  8. Retirement

    Compounding Is Important in the Later Years Too

    The power of compounding is even greater in the later years of saving for retirement.
  9. Investing

    Investing $100 a month in stocks for 30 years

    Find out how you could potentially earn hundreds of thousands of dollars just by investing $100 a month in stocks during your working years.
RELATED FAQS
  1. How do I calculate compound interest using Excel?

    Learn how to calculate compound interest using three different techniques in Microsoft Excel. Read Answer >>
  2. Mutual Funds and Compound Interest

    Learn how mutual funds can grow wealth over time through the magic of compound interest by reinvesting dividends back into ... Read Answer >>
  3. Yield vs Interest Rate

    Yield is the dividend or interest investors receive from a security, while interest rates are figures charged by a lender, ... Read Answer >>
Trading Center